Just how high will oil prices go? (page 1 of 2)

Since its last major low in 1998 at $12 (when The Economist published a very bearish piece about oil), crude oil prices have climbed to around $50 at present. The question, therefore, arises whether oil prices are headed for a sharp fall, as most analysts seem to think, or whether far higher prices could become reality in the years to come.

Over the last two years we have repeatedly explained how rising demand for oil in Asia would likely lead to higher prices - this especially because we took the view that the oil producing countries in the world were unlikely to be in a position to increase their production meaningfully.

At $50, one might, however, be tempted to think that oil prices are substantially over-bought - certainly from a near term perspective - and ready to decline again. Therefore, I have noted that numerous market participants have been shorting oil futures in the hope of a sharp fall.

I do agree that near term oil prices might succumb to some profit taking. Bullish consensus runs above 80% and oil has become a popular topic of discussion in the media and at every investment conference I attend.

Moreover, the US administration could decide to sell oil from its strategic reserve, which currently exceeds 630 million barrels. Thus to sell daily 2 million barrels into the market amounting in total to 120 million barrels over a two months period would be an option if prices continued to soar.

Also, since Chinese oil imports were up so far in 2004 by more than 40%, I suspect that some inventory accumulation also occurred in the Middle Kingdom.

Therefore, if the Chinese suddenly decided to curtail their oil imports the same way they stopped buying soybeans in March 2004 - an event which led to an almost 50% decline in prices - prices could come under some near term violent pressure! Still, I maintain the view that we may see sometime in future far higher prices than anybody envisions.

First of all, if we look at oil prices in real terms - that is oil prices adjusted for inflation - the real prices is right now still about 50% lower than it was at its January 1980 peak. In fact, oil is now not much higher than it was in the early 1970s, when the last big oil bull market got underway.

But, what is important to understand is that whereas the 1970 oil price increases were coming from a supply shock, which was driven by OPEC cutting its production all the while large production excess capacities existed, the current oil bull market is purely a function of increased demand coming principally from Asia at a time global oil production has practically no spare capacity which could lead to much higher production than the current 80 million barrels per day.

So, whereas we can say that the 1970s oil shock was "event driven", today's oil price increase is structural in nature. Specifically the current demand driven oil bull market is fueled by the incremental demand coming from the industrialization of China and the rising standards of living around Asia, which increase the population of energy using consumer durables such as motorcycles, air-conditioners, and cars very rapidly.

Just consider that China's car population has more than doubled since 2002 and that it is up tenfold since 1994! Thus, as mentioned above, oil imports of China have risen by 40% so far in 2004. And while I certainly do not believe that Chinese oil imports will rise every year by 40%, it is equally unlikely that oil imports into China will ever decline again meaningfully.